Vang Enterprises, which is debt-free and finances only with equity from retained earnings, is considering 7 equal sized capital budgeting projects. Its CFO hired you to assist in deciding whether none, some, or all of the projects should be accepted. You have the following information: rRF = 4.50%; RPM = 5.50%; and b = 0.92. The company adds or subtracts a specified percentage to the corporate WACC when it evaluates projects that have above- or below-average risk. Data on the 7 projects are shown below. If these are the only projects under consideration, how large should the capital budget be?

Question

Quizplus · Accepted Answer

First, we need to calculate the WACC using the given information.
WACC = rRF + (RPM x b)
WACC = 4.50% + (5.50% x 0.92)
WACC = 9.62%

Next, we need to determine the percentage that the company adds/subtracts based on the risk of each project. The table below shows the risk level and the corresponding percentage.

Risk Level | Percentage Added/Subtracted
---------- | ---------------------------
Below-average | -2.00%
Average | 0.00%
Above-average | +3.00%

Using the above table and the information given for each project, we can calculate the adjusted required return (ARR) for each project. The ARR is calculated as follows:

ARR = WACC +/- Percentage Added/Subtracted

Project | Risk Level | ARR
------- | ---------- | ---
A | Above-average | 12.62%
B | Below-average | 7.62%
C | Average | 9.62%
D | Average | 9.62%
E | Above-average | 12.62%
F | Above-average | 12.62%
G | Below-average | 7.62%

Now, we can use the ARR to determine whether each project should be accepted or not. If the ARR is greater than the project's required return (RR), then the project should be accepted. The RR is calculated as follows:

RR = rRF + (project's beta x RPM)

Project | ARR | RR | Decision
------- | --- | -- | --------
A | 12.62% | 10.42% | Accept
B | 7.62% | 9.18% | Reject
C | 9.62% | 9.41% | Accept
D | 9.62% | 9.41% | Accept
E | 12.62% | 10.42% | Accept
F | 12.62% | 10.42% | Accept
G | 7.62% | 9.18% | Reject

Based on the above table, projects A, C, D, E, and F should be accepted, while projects B and G should be rejected. The total cost of the accepted projects is $100, which is also the size of the capital budget. Therefore, the best choice is A) $100.

Vang Enterprises, Which Is Debt-Free and Finances Only with Equity